Industrialization of Kerala: The Insiders’ Perspective

Dividend theory

James E Walter (1963) is an advocate of the dividend relevance theory. This theory states that the retention of earnings of dividend payment influence shareholders’ wealth differently. He assumes three cases that are

1. When the return on new investment is greater than the market capitalization rate, it is the retention of earnings and their investment that will raise the value of shares.

2. When the return on new investment is equal to the market capitalization rate, both the retention of earnings and dividend payment will have the same impact on the value of shares.

3. When the return on new investment is lower than the market capitalization rate, it is the dividend payment, and not the retention of earnings, that will raise the value of shares.

Walters formula P= D+(E- D)r/k

K

P= Price per equity share, D= dividend E= earnings per share, r= rate of return on investment k= cost of capital

Example

Growth firm Normal firm Declining firm

r> k r=k r < k

r =20% r = 15 % r =10%

k = 15% k = 15% k = 15%

E = 4 E = 4 E = 4

If D = 4 If D = 4 If D = 4

P = 4 + (0) .20/.15 = 26.67 P = 4 + (0) .15/.15 = 26.67 P = 4 + (0) .10/.15 = 26.67

.15 .15 .15

If D= 2 If D= 2 If D= 2

P = 2 + (2) .20/.15 = 31.11 P = 2 + (2) .15/.15 = 26.67 P = 2 + (2) .10/.15 = 22.22

.15 .15 .15

From the above

· When rate of return is greater than cost of capital (r > k) the price per share increases as the payout ratio decreases

· When rate of return is equal to cost of capital (r = k) the price per share does not vary with changes in dividend payout ratio

· When rate of return is less than cost of capital (r < k) the price per share increases as the payout ratio increases

GORDEN MODEL

Myron Gorden proposed a model of stock valuation using the dividend capitalization approach

Assumptions

· Retained earnings represent the only source of financing for the firm.

· The rate of return on the firm’s investment is constant

· The growth rate of firm is the product of the retention ratio and its rate of return.

o Cost of capital for a firm remain constant and it is greater than the growth rate

o The firm has a perpetual life

· Tax doesnot exist

Formula of Gorden P= E1 (1-b)

k-br

where Po= price per share at the end of year 0

E1 = earnings per share at the end of the year 1

b = retained earnings

(1-b)= fraction of earnings the firm distribute as dividend

k = rate of return required by the shareholders

r = rate of return earned on investment made by the firm

br = growth rate of earnings and dividend

Example

Growth firm Normal firm Declining firm

r> k r=k r < k

r =20% r = 15 % r =10%

k = 15% k = 15% k = 15%

E = 4 E = 4 E = 4

If b = .25 If b = .25 If b = .25

P = (.75)4 = 30 P = (.75)4 = 26.67 P = (.75)4 = 24

.15-(0.25)(0.20) .15-(0.25)(0.20) .15-(0.25)(0.20)

If b = .50 If b=.50 If b=.50

P = (.50)4 = 40 P = (.50)4 = 27.67 P = (.50)4 = 20

.15-(0.50)(0.20) .15-(0.50)(0.20) .15-(0.50)(0.20)

Here the basic Gorden model leads to dividend policy implication as that of walter model

· Optimum payout ratio for growth firm (r>k) is nil

· Payout ratio of normal firm is irrelevant

· Optimum payout ratio for declining firm (r

DIVIDEND IRRELEVANCE –MM approach (Modigliani- Miller hypothesis)

Assumptions

· Perfect capital market

· All investors are rationale and have identical beliefs

· Information is available

· No transaction cost and taxes do not exist

Under these conditions, distinctions of dividend or otherwise has the same impact on the shareholders wealth. As a consequence, the shareholders are indifferent between the payment of dividend and and the retention of earnings.

They assume four situation, In all these situation, the value of shareholders wealth remains the same. They are

1. The firm retains the entire earnings and does not declare dividend.

If each share of a firm is selling at Rs 100, and the firm is thinking of declaring a dividend of Rs 5 at the end of the first year, but ultimately it does not declare dividend. The value of shareholders wealth in the case of shareholder possessing one share at the end of first year, assuming capitalization rate of 10% will be Rs (100(1.10)-0) = Rs 110

2. If the firm possess the required cash to pay dividend. If the dividend is paid out of cash, money is transferred form one firm to the shareholders hand. The value of shareholders wealth will remain the same, that is, equal to the sum of the value of their shares and the amount of cash dividend they receive.

a. On the b asis of the example in abve case, the value of share at the end of first year will be Rs (100(1.10)-5)=105. In case of shareholder holding one share the value of shareholders wealth will be the value of one share + the cash received as dividend ie = Rs 105 + 5 = Rs 110

3. If the firm does not possess sufficient cash to pay dividend, it issues share in lieu of cash and allots these shares to the existing shareholders. The share holders wealth remains the same because they get either cash or shares or the same value.

4. If the company issues new shares in lieu of cash payment dividend, but the shareholders need cash, then, in such case, the shareholders would sell their newly issued shares either in full or in part to some new investors and get cash. In this case too, the share holders wealth remains the same. It is the sum of value of the existing and new shares and the cash received from the new investors in exchange for the shares. The transactions involving the sale of shares by the existing shareholders to the new investors in known as a “homemade dividend”

Capital structure and value of the firm

Capital structure is the type and proportion of source of fund used in the total capital of the firm.

Ie the ratio between owned capitals borrowed capital

Determination of optimum capital structure

1. The lowest WACC

2. Corporate income tax and personal income tax- dividend is not taxed form share holder but interest is charged. So the shareholders personal income tax is lower than bond holders. It reduces the advantage of corporate borrowings and value of the firm

3. Bankruptcy and agency cost- when degree of financial leverage increases, the probability that the firm will be unable to meet its financial obligations also increases. Any continuance of this problem may lead to financial distress, default and ultimately bankruptcy- bankruptcy cost are accounting and legal fee, reorganization cost, loss of profit higher cost of credit etc…

4. cost of external finance

Features of sound capital structure

1. perfect trade off between risk and return

2. minimum cost of capital

3. sufficiency of cash flow to service debt

4. maintenance of industrial norms

5. flexibility

Theories of capital structure

The key question is whether a firm can affect its total valuation (debt + equity) and its cost of capital by changing its financing mix. That is what happen to total value of the firm and its cost of capital when the ratio of debt to total capital is varied.

A number of theories explain the relationship between cost of capital, capital structure and value of the firm.

1. Net Income approach

2. Net operating Income approach

3. Traditional approach

4. Modigliani Miller approach

Before discussing theories the assumptions are

1. The firm finances from two source only debt and equity

2. There is no corporate tax(the assumption is removed later on)

3. There is no retention of earnings (100% dividend payment)

4. Operating income is expected to remain constant

5. The firm can change its capital structure

6. No transaction cost

7. The company has a constant operating cost.

Net Income approach

Durand identified the two extreme capital structure theories- NI approach and NOI approach

Under NI approach the firm is able to increase its total valuation-v, and low its cost of capital-ko, as it increases the degree of leverage. The optimum capital structure is one at which the cost of capital is the lowest and value of firm is greatest. At that structure market price per share is maximized

It is applicable when

- The cost of debt (kd) is less than the cost of equity (ke) and it remain constant

- The firms risk perception is not changed (increase in debt does not create risk in the mind of investors.)

I II III IV

Equity (cost 10%) 100000 80000 50000 20000

Debt (5%) --- 20000 50000 80000

Total 100000 100000 100000 100000

EBIT 15000 15,000 15,000 15,000

(-) Interest --- 1,000 2,500 4,000

Profit to Equity shares 15,000 14,000 12,500 11,000

Market value of debt ---- 20,000 50,000 80,000

Market value of equity(profit /cost of E)150,000 140,000 125,000 110000 Total value 150,000 160,000 175,000 190,000

Kd 5% 5% 5% 5%

Ke 10% 10% 10% 10%

Ko 10 9 7.5 6

(ko = (proportion of debt X rate) + (proportion of equity x rate or cost))

Ko= 0 x 5 + 1 x 10 = 10

= .2 x 5 + .8 x 10 = 9

= .5 x 5 + .5 x 10 = 7.5

= .8 x 5 + .2 x 10 = 6

graph

NOI approach

Assumption 1. over all cost of capital ko does not vary because in use of cheaper debt capital kd is offset by an increase in the cost of equity ke thus the weighted average cost of ko remains unchanged

2. The value of firm is found by capitalizing the net operating income(EBIT)

V = EBIT

ko

The EBIT and ko are constant so ther is no change to value of firm if leverage changes.

Graph

Traditional approach

The traditional approach lies mid way between NI and NOI approach. It is in fact a compromise between two and is known as intermediate approach.

- the use of debt capital increases the value of the firm and reduces cost of capital upto a certain point . After that the increase in cost of equity off set the use of cheaper debt capital in capital structure.

MM approach

Assumptions

1. The firms pays no tax

2. There is no transaction cost(investors borrow and lend money at the same interest rate)

3. Investors have the same expectations as to firms future earnings and risk

4. Future financing decisions do not affect firms investment in assets.

Consider there are two firms U is unleveraged meaning that the entire capital is made up of equity share capital and other L is a leveraged means capital represents a debt and equity mix. Let us further assume that firm L has higher market value on account of its being leveraged.

The MM hypothesis suggests that the difference in market value between the two firms cannot persist because the shareholders will indulge in a process of arbitrage or home made leverage, buying the low value shares and selling the high value shares. The share holders of firm L will realize a greater return on their shares without any increase in their investment or in their risk perspective. The arbitrage process will occur as follows

1. The shareholders will sell their shares in firm L

2. They will borrow and create their own personal leverage similar to firm L”s capital structure.

3. They will use all the resultant cash to purchase shares in firm U

The selling of firm L’s shares and purchase of firm U’s shares will continue till the market value of the shares of both firm is equal. When the value of two firms is equalized, the process of arbitrage ceases.

Example Firm U firm L

Operating income 50,000 50,000

Interest 12% 0 18,000

Net income 50,000 32,000

Market value of equity 2,50,000 150,000

Market value of debt ------ 150,000

Total market value 250,000 3,00,000

Suppose an equity share holder owns 1% shares of the leveraged firm L. as per MM hypothesis, he will sell these shares at the market value of Rs 1500 and subsequently, he will borrow an identical amount ie Rs 1500 at 12% interest. This creates a personal leverage ratio of 50% which is exactly similar to the firms’ capital structure. Finally, with the entire amount of Rs 3000, he will purchase the shares of the unleveraged firm which will be equal to (3000/2,50,000)= 1.2% shares of U. prior to the there – step arbitrage the investors’ share of return in the leveraged company’s net income was Rs. 320 (ie 1% of Rs 32000). After arbitrage, it is Rs 600 (ie 1.2% of Rs 50,000) minus interest charge of Rs 180 (12% of 1500) = Rs 480. Thus the investor without adding any fund, has an investment with an identical amount of leverage that earn (420-320)= Rs 100 more on account of arbitrage.

Lured of profit, he will continue selling shares of the leveraged company and buying shares of the unleveraged company until the market value of the two firms becomes equal.